This article was written by Ipek Ozkardeskaya, Senior Market Analyst at FCA regulated broker London Capital Group Holdings plc (LON:LCG).
Although volatility does not predict the direction of a price move, a highly volatile environment usually couples with a bearish market. This is because investors may be in a hurry to reverse or unwind their positions and to make readjustments in their investment portfolios.
In contrary, the bull market is often associated with lower volatility and smoother price action, as investors are gradually convinced to build new positions or to readjust the existing ones.
Golden Rule: Positive or negative, high volatility is a risk in both directions. It is a sign of panic in the market. Large gains could rapidly be reversed by even larger losses.
If you imagine a two-axis chart; with the stock price in the x-axis and the volatility in the y-axis, you will see what finance masters talk about when they say ‘volatility doesn’t smile, it smirks’.
For FX traders, volatility could generate opportunity and rapid gains. Nevertheless, the risk of entering positions in volatile market conditions should be managed carefully.
Volatility based position management is key for a successful trade. As we reiterate, by entering a position, you are only a half way though the success.
Successful traders often use volatility indicators to manage their positions in order to define the risk they are ready to take for a targeted return. The idea is to minimise the size and the number of losing trades and to maximise returns in given market conditions.
This concretely means, if you are dealing with high market volatility, you may want to place your stop far enough to avoid getting stopped out too early and writing-off losses in a position, which otherwise would have led to gains.
One of our favourite volatility indicators in LCG is the Average True Range (ATR). The ATR is a widely used volatility indicator. It is the moving average of the true ranges. The 14-period moving average is the most commonly used and will pop up by default on your LCG Trader platform.
The true range is the greatest of:
- the difference between the current high and the current low,
- the absolute value of the current high less the prior close price or,
- the absolute value of the current low less the prior close price.
How to use ATR?
Don’t get confused by the mathematical definition, because first, no one expects you to compute the ATR. Secondly, and perhaps more importantly, once you know how to read this indicator, it is very simple to use.
The ATR is expressed in pips. If the 14-day ATR on AUDUSD is 0.0099. This equals 99 pips.
In this particular context, a trader opening a long AUDUSD position at 0.7305 could set the stop loss 99 pips below at 0.7206. In a similar way, a trader entering a short AUDUSD position could set the stop loss 99 pips higher at 0.7404.